Since the beginning of human civilisation, a medium of exchange has been considered the crucial item widely used in the exchange of goods and services.
“Medium of exchange in economics refers to a reliable, widely, and legally accepted intermediary, transitional or financial instrument having inherent worth. This worth is utilised to assign value to commodities and services for trade and exchange between their owners. It aims to promote the sale & purchase of goods and services as per their value for the proper functioning of the economy,” explains ‘WallStreetMojo’.
The prevalent medium of exchange in the 21st century economy is money, which allows buyers and sellers to pay less in transaction costs, compared to barter trading.
“If there were no money, we would be reduced to a barter economy. Every item someone wanted to purchase would have to be exchanged for something that person could provide,” states the International Monetary Fund (IMF).
Types of money
The first one is called ‘commodities’, whose physical properties make them ideal as a medium of exchange.
Commodities are goods/products that can be traded across markets. All sorts of raw materials, be it wheat, steel, oil or coffee, and even physical goods like gold, diamonds, silver and platinum are considered commodities.
While physical commodity markets trade things like raw materials and agricultural products, futures markets deal with contracts to deliver the underlying commodities at a specified price at an agreed-upon date.
Another type of money includes government-issued legal tender or fiat money. Fiat money is not backed by a commodity like gold or silver. Usually, the government of a country issues and designates the fiat money as legal tender.
Fiat money also does not possess either intrinsic or use values. Its value lies in the fact that it is used by individuals as a unit of account, or, in the case of currency, an exchange medium, based on an agreed value.
The first recorded use of government-issued fiat money banknotes was in 11th century China. It became more prevalent during the 20th century, as former United States President Richard Nixon’s decision to suspend US dollar convertibility to gold in 1971 fuelled the global use of national fiat currencies.
Fiat money also allows the issuing government to conduct its economic policy by increasing/reducing the money supply. In the United States, the Federal Reserve and the Treasury Department monitor several types of money supplies to regulate monetary issues.
Since fiat money does not represent a real commodity, the issuing government also has the responsibility to ensure that it meets the necessary properties of the money.
The International Monetary Fund (IMF) and World Bank serve as global watchdogs for the exchange of international currencies. Additionally, governments may enact capital controls to stabilise their currency on the international market.
Also, traders exchange money substitutes like written debt statements that can be redeemed later. These statements also adopt some of the money’s properties, in case traders use them instead of actual currency.
During ancient times, banks used to issue exchange bills to their depositors, stating the deposited amount, along with the redemption terms. Instead of withdrawing money from the banks to make payments, depositors used to trade their bills.
This kind of substitute can increase money’s portability and durability, apart from reducing the storage cost.
“However, there are risks involved with money substitutes. Banks may print more bills than they have money to redeem, a practise known as fractional reserve banking. If too many people try to make withdrawals at the same time, the bank may suffer from a bank run,” Investopedia stated.
The final money type includes the ‘Fiduciary Media’, which are money substitutes introduced into circulation and are not backed by the base money held to back money substitutes. Paper checks, token coins, and electronic credit are some examples of fiduciary media.
Money is a liquid asset
“Liquid assets include cash and other assets that can quickly be turned into cash without losing value. You always want some of your assets to be liquid to cover living expenses and potential emergencies. But in a larger sense, think of liquidity as a spectrum: Some assets are more readily convertible into cash than others. At the far end of the spectrum are illiquid assets, which are very hard to value and sell for cash,” comments Forbes Advisor.
Yes, money is a liquid asset, which is used to facilitate transactions of value. In simple words, money is used as a medium of exchange between individuals and government/private entities. Money is also a store of value and a unit of account that measures the other goods’ value.
Money or the very idea of cash has an intrinsic relationship with ‘Liquidity’. An asset is considered a ‘Liquid’ one only when it is exchanged for money. Cash is the most liquid asset, as having it in a bank/credit union account will enable an individual/entity to access the currency quickly, either by a bank transfer or by an ATM withdrawal.
Owning liquid assets, for example, cash, often allows an individual to pay for living expenses and handle emergencies.
“But it’s important to recognise that liquidity and holding liquid assets comes at a cost. In general, the more liquid an asset is, the less its value will increase over time. Completely liquid assets, like cash, may even fall victim to inflation, the gradual decrease in purchasing power over time,” Forbes commented further.
Phenomenons like inflation, recession and global economic slowdowns are very common in the 21st century global landscape, and if you are living in a country currently going through either of the above uncertain scenarios, then the potent weapon against it is the tool called ‘Long-term Financial Goal’.
Here also money comes in handy, as you can use this liquid asset to invest in areas like mutual funds, provident funds, real estate and so on, strategic investments that will help grow your wealth over time.
“But assets like real estate, as well as art and jewellery, may be considered highly or even exclusively illiquid. This doesn’t mean that you will never receive cash for them, only that it can be more challenging to value assets like this and then turn them into cash,” warned the Forbes report.
Properties of money
Money should have functional properties. It has to be fungible, durable, portable, recognisable, and stable. These properties reduce the transaction cost of money by making the latter exchange.
For an item to be considered money, it must be widely accepted as payment for goods and services. Money creates that efficiency factor as it eliminates the uncertainty regarding the accepted payment medium for businesses.
“Money also needs to be a fungible one, a quality that allows one thing to be exchanged, substituted, or returned for another thing, under the idea of ‘Equivalent Value’. For an item to be considered money, it should and must be the unit by which commodity prices and bank balances will be decided and reported. Having a consistent unit of account creates efficiency since it would be pretty confusing to have the price of bread quoted as a number of fish, the price of fish quoted in terms of t-shirts, and so on,” states a Though.Co report.
While metal coins should have a standard weight and purity, the commodity counterpart should be relatively uniform in quality. Trying to use a non-fungible entity as money will result in transaction costs that will involve individually evaluating each unit of the good before an exchange can take place.
“Money should be durable enough to retain its usefulness for many, future exchanges. A perishable good or a good that degrades quickly due to various exchanges will be less useful for future transactions. Trying to use a non-durable good as money conflicts with money’s essential future-oriented use and value,” explains Investopedia, while explaining money’s ‘Durability’ criteria.
“Also, money should be easy to carry and divide so that a worthwhile quantity can be carried on one’s person or transported. For example, trying to use a good that’s difficult or inconvenient to carry as money could require physical transportation that results in transaction costs,” it stated further.
The authenticity and quantity of the goods (money) should be easily apparent to users so that the latter can easily agree to the exchange terms. Also, if an item wants itself to be considered as ‘money’, its purchasing power should hold itself against market conditions for a longer period. Also, the supply of the entity, considered as ‘money’, should remain constant over time, to prevent value fluctuations.
Money’s key functions
It primarily functions as a medium of exchange for items/goods and services having value. Money is treated as the parameter to measure the value of a product/service. Money, in a broader sense, is the universal medium of exchange for items/goods, while currency, the tangible form of money, differs across countries.
Among the secondary functions of money, money is also the unit of account, when it comes to the medium of exchange for buying and selling and assigning values to goods and services. Money can keep track of changes in the items’ value over time. Money also gets used to compare the values of various combinations/quantities of different goods and services.
Money can be stored or conserved through savings accounts and strategic investments for future purposes, apart from increasing someone’s net worth. For businesses, money also serves as the principal accounting unit, when it comes to measuring profits and losses, balancing and preparing a budget for a financial year, and last but not least, deciding the value of the total assets and liabilities of the company.
“It was very difficult to store wealth in terms of goods because of their perishable nature and high cost. Money provides a solution to this problem as one can store money for as long as possible. Money has the quality of universal acceptability. Therefore, one can at any time use money in exchange for goods and services. Money is easily portable, and saving money is much easier and more secure than saving goods for future use,” states an explainer from geeksforgeeks.org.
As people exchange items for money, that money retains a particular value which can be used throughout other transactions. Given its capacity to retain value, money can be used for deferred payments too.
You have the investment industry, which makes the best use of the above attributes. In 21st century, several investment vehicles like ‘Buy Now, Pay Later’ and ‘Payment Plans’ have been structured with deferred payment options. Even the loans and mortgages come with the deferred payments option. If someone borrows a certain amount from another individual or a lending body, they can repay the amount with interest, in an agreed-upon period. This simple principle has enabled the growth of lending and borrowing.
Also, money’s utility can be used to purchase goods from overseas markets too, by exercising the principle of ‘transferring the value’. Yes, currency, as a tangible form of money, differs across countries, but the basic idea around money remains the same around the globe.
In short, money’s steady market availability has contributed to the overall stability and liquidity in the global economic order, apart from establishing the functions of the money markets.
Can cryptocurrencies be considered money?
In January 2009, Bitcoin was created by pseudonymous developer Satoshi Nakamoto. And by 2023, these digital currencies will become a rage. These digital currencies have fascinated the tech geeks around the world, due to their use of encryption algorithms, digital wallets and virtual exchanges.
However, the crucial question that emerges here is whether these currencies can too be brought under the wide spectrum called ‘money’. The answer is no.
As of 2023, virtual currencies have not been issued/controlled by a central bank or any other regulatory authority. These currencies are issued and controlled by private exchanges like Binance.
According to the US Library of Congress’ November 2021 data, some nine countries have completely banned cryptos, while 42 others have put other sorts of restrictions.
Although cryptos have achieved utility as a speculative investment, and a country like El Salvador has already recognised these digital currencies as a payment mode, the recent market bloodbath due to the downfall of the FTX exchange, along with the regulatory actions against the crypto businesses in the United States have brought these currencies under more scrutiny.